Topic 2 European Monetary Cooperation 1 2 reasons for cooperation:1 political: increased monetary co-operation would lead to pressure for increased political integration. Institutional: payment mechanism within EU would be made easier if currency exchanges were limited Trade: reducing exchange rate movements would further enhance the free trade area of Europe cooperation:2 historical: past experiments at floating exchange rates seen as being unsuccessful. Power: individual European countries were not major world powers, together, they were more important Lower interest rates and inflation rates? Reduced amplitude of business cycle? 3 Policy trilemma (can only have 2/3) Capital mobility Stable exchange rates Monetary policy autonomy (ability to do it individually for your own country without looking at your own) 4 chronology (moodle) 69/70: werner report 71: Smithsonian agreement, fluctuation bands widen to 4.5% 72/73: nake in the tunnel -bilateral parities withing eu could fluctuate 2.25% within tunnel defined by dollar parities 73: European monetary co-operation fund 79: setting up of erm of ems- irish punt floated against sterling 5 Chronology 89: delors 3stage plan for monetary union (werner mark2) Madrid summit -stage1 to start in June 1990 91: Maastricht summit, criteria for entry to EMU agreed 92-3: Currency crisis 95: changeover to single currency published by European monetary institute 6 chronology 99: exchange rates fixed, euros used as unit of account and as a means of payment in financial transactions. EMI replaced by European central bank, ECB and the European system of central banks (escb). 11 countries took part 99: erm 2, for countries not in single currency- Greece and Denmark 01: Greece joined the single currency having been deemed to meet the Maastricht criteria 02: euro currency commenced circulation 08: ten years of the euro celebrated 10- crises! Will the euro survive? 7 8 setting up a new exchange rate system? Decide: what is the anchor of the system – ECU (comprises of many currencies) when intervention is necessary, who intervenes? – Both strong and weak How is intervention to be funded? – European cooperation fund What flexibility is to be allowed? – 2.25% (Italy 6%) around ECU central parity How are realignments to be handled? – mutually agree, following discussion -divergence indicator Operation of erm to ez (gros& thygensen) Initial turbulent start, 1979-83. Calmer intermediate phase, March 1983- Jan 1987. Success at last? Jan 1987- August 1992. Turmoil in Currency market, sept. 92- July 93 Erm- broad bands, preparation for emu 93-98 Erm 2- 1999, non emu members and (some) accession countries First 10 years of emu seen as a success Crisis periods showing up as weaknesses 9 currency crisis 1992 -1993 economic environment: Collapse of trade with Soviet Union Pressure on interest rates and inflation rates due to GMU Pressure on interest rates and inflation rates, due to gmu Weak dollar damaging to european competitiveness Deficits reducing policies in place Recession Political German preoccupation internal problems Franc for policy Uncertainty over Maastricht ratification process 10 currency crisis outcome speculative attack against the erm of ems attempts to defend the erm using high interest rates and interventions Italians first to be devalued After ‘black Wednesday’ sterling left the system Finnish and Swedish unilateral pegs suspended Irish punt eventually devalued by 10% at end January 1993 These measures were not sufficient- eventually in summer 1993, the bands were widened to 15% This compromise was seen as the end of the erm, and the end of the emu project (ended up delaying by about 3 years) 11 Reasons for the crisis Unsustainability of currency pegs, where capital is mobile (the policy trilemma) Self- fulfilling currency attacks Pegging policy too costly in terms of unemployment, high interest rates etc German political and monetary union, and franc fort policy -the assymetric shock problem 12 lesson from the currency crisis intermediate exchange rate regimes are inherently unstable- either have fully fixed or fully floating pegged, but adjustable exchange rate regimes may be inconsistent with the free flow of capital -limits on capital flows are necessary speculative attacks on pegged but adjustable exchange rate regimes inevitable you can’t win against the market early adjustment to exogenous shocks required 13 European monetary union motivation: managing the German current account surpluses anchoring to a low inflation country would give low inflation fiscal discipline needed- stability and growth pact common banking supervision discussed, but not adopted – revisited during crises period 14 Euro : the early years euro accepted as major world reserve currency, an alternative to the dollar during periods of dollar weakness. Could it take over as the major international reserve currency if dollar weakness continues Monetary policy for the euro zone countries centralised at the European central bank in frankfurt 15 euro the early years, ctd worries as to whether this central bank will be independent or whether it will be over influenced by member governments like the Bundesbank, it has its core objective monetary stability, with growth in output and employment only secondary objective stability and growth pact deficit limits exceed by those who had insisted on its inclusion (Germany and France) but no fines imposed 16 ecb and monetary policy (moodle) 17 euro the first 10year initial period: euro depreciated against dollar, going from $1.11 per euro to close to parity in July 1999 from a high of $1.18 below parity with the dollar for three years, 2000-2, reaching lows of .83, despite intervention by world central banks, and interest rate increases by the European central bank extended period of dollar weakness in 2007 on difficulties for euro zone exporters to dollar area, and those trying to attract us tourists to Europe – particularly difficult for Ireland ‘currency wars’? 18 policy tool: interest rates increase if there are inflationary pressures reduce in times of recession one policy fits all? Too early an increase in interest rates because of inflationary pressure in centre countries exacerbates problems in slow growing peripheral countries and makes banking problems worse 19 (look at graphs on moodle) 20 Could the euro project fail?(pre-crisis viewpoint) No: Countries have too much political stake in the project No mechanism for leaving the euro has been outlined (going from strong currency to weak) The European institutions are strong The economic consequences of going it alone are profoundly negative The new central bank has had strong leadership and the euro has been accepted as major world currency 21 could the euro project fail? (pre-crisis viewpoint except blue line) yes: history says that all exchange rate regimes are temporary lack of fiscal coordination means problems of deficit countries affect all devaluation option attractive over-rapid absorption of new member states into the euro could undermine confidence and lead to pressure for looser monetary policy political reluctance to support highly indebted countries (piigs – Portugal Ireland Italy Greece spain) 22 euro at 10 (2008) ‘resounding success’ Self-congratolary tone Some clouds ahead acknowledged Financial stability not mentioned (De Grauwe.2013) 23 international crisis to euro crisis:1 was slow to follow other central banks in reducing interest rates in response to the crisis- remained worried about inflation for longer interest rates at zero extended special lending facilities to European banks in trouble (slow increment to reacting to the next crisis) Maastricht deficit criteria suspended Quantitative easing policy belated adopted 24 international crisis to euro crisis: 2 ‘super mario’ – all that needs to be done will be done Greece was danger of defaulting on its own soverign debt, helped by ecb and imf, despite ‘no bail-out’ clause’ of original emu treaties Grexit a real possibility 2011,2013 Sovereign borrowing costs highly variable in crisis Piigs in trouble 25 Monetary arithmetic in a monetary union Country with their own currency can monetise the debt (sargent and Wallace) to avoid default Countries without their own currencies may not, meaning the default premium is large, once crisis occurs (DeGrauwe, Sims) Ecb, by statue may not lend to the governments, the ‘no monetary financing’ clause 26 international crisis to euro crisis ‘quantatitive easing’ in uk and us Ireland and Portugal joined Greece in needing help, spain Italy in difficulties Emergency liquidity measures, meant to be short term, extended Eventually qe in ez 27 no bailouts allowed! Pre-crisis, a Greek promise was considered as good as a german promise, so many german and French banks held Greek sovereign debt, as it had a slight premium over german debt Once crisis hit, capital flight from piigs to centre countries, undermining banking system Partial write down of Greek debt 28 from crisis to crises liquidity crisis banking crisis sovereign debt crisis political crises contagion and fears of contagion irrational exuberance to excessive caution? 29 ecb and the crisis European financial stability facility created and (eventually) allowed to buy sovereign bonds on the secondary market Securities market progamme (2010) allowing ecb to buy sovereign debt in primary and secondary markets- two german members of ecb resigned Long term re financing operation (11-12) 30 what needs to be done? Completing the banking union; 31 Breaking the ‘doom loop’ between banks and their sovereigns; Ensuring ez-wide risk sharing for Europe wide shocks; Cleaning up the legacy debt problem Coordination ez-level fiscal policy while tightening national-level discipline; Advancing structural reforms for a better functioning monetary union euro ongoing